Sadly, 'Death of Derivatives Overhaul' Rumors Are Greatly Exaggerated

by: Craig Pirrong

Saturday’s WSJ carries a story lamenting the “death” of derivatives overhaul. Like Twain’s, rumors of this death are exaggerated. The derivatives “reforms” that passed the House before the holiday were not immaterial, even if they were not everything supporters were hoping for (and thank God for that).

The main complaint is that the OTC markets were not killed by forcing all trading onto exchanges, a la the Grain Futures Act of 1922 (how’s that for a model of modernity!?), and that customers were given some exemptions from a clearing requirement.

The article quotes Stanford’s Darrell Duffie’s explanation for resistance to the bill:

For Wall Street, switching to exchanges would have cut their profits in a lucrative business. “Exchanges are anathema to the dealers,” because the resulting added price disclosure “would lower the profits on each trade they handle, and they would handle many fewer trades,” said Darrell Duffie, a finance professor at Stanford business school.

Darrell is a very smart man–a helluva lot smarter than me–but in this instance he is lost in (Hilbert?) space. Sure the dealers want things their way. GM (OTC:MTLQQ) wants people to buy their cars, too. But wanting it doesn’t make it happen. That’s called magical thinking, which has a rather bad habit of running smack dab into reality.

And here, the reality is that it was customers–those allegedly the victims of the dealers–that argued strenuously for the exemptions. Again, how does anyone (including Darrell) explain this?: Stockholm Syndrome? Battered Spouse Syndrome?

Another reality is even plainer: Dealers evidently offered end-users a superior bundle of pricing, product design, transparency, and credit and collateral arrangements, as compared to exchange-traded alternatives. Exchanges have striven hard to make inroads into the OTC business. There was no major entry barrier preventing somebody or several somebodies from starting exchanges. But OTC grew absolutely and relative to exchanges nonetheless. Like it or not, the OTC market won in a competitive battle against the exchanges.

It would be nice if somebody asked “why?” They might find the answer somewhat illuminating.

There is also an element of intellectual incoherence here. (More than an element, actually, but I’m in a giving holiday spirit.) One of the supposed justifications for clearing is that dealers are too inter-connected. But as written, the legislation forces clearing on dealers–thereby just creating another form of inter-connection.

The primary economic justification for clearing is to protect customers against dealer (or FCM) default. After all, for years the Board of Trade Clearing Corporation touted the fact that

no customer has lost money as a result of a default by a clearing member to BOTCC.

Note the (emphasized) fact that the CUSTOMERS didn’t lose money as a result of a clearing member to BOTCC. Other members of BOTCC had to cover the costs of clearing member defaults. Note too the careful wording–some customers can, and have, lost money as a result of member defaults, but the chain of losses didn’t run through BOTCC.

Put differently, the primary justification for clearing is that it improves the quality of service that customers of intermediaries receive. A clearinghouse made this argument for decades. But the legislation leaves out the customers, by and large. Because the customers want it that way, and have made that preference clear through both their economic choices and their lobbying voices. So what’s the point?

There are other stories that speak to the incoherence of the whole mandated clearing effort. It is finally dawning on some that the creation of one clearing house will create a massive point of vulnerability, but that multiple clearinghouses will require these to be inter-connected. Thus, the idea of using clearing to eliminate, or even reduce, systemic risk by eliminating inter-connections is a complete mirage.

These remarks by Pierre Gay, Asia-Pacific head of Newedge, the world’s largest futures broker, are priceless:

But forcing all such business to pass through a central clearer would be “a bit too much”, he argued in an interview with the Financial Times.

“The risk we see is that . . . it would transfer the risk from bank to bank, to a clearing house, which, being private, would also have to make a profit and we could create a globally risky situation.”

Mr Gay said clearing was one possible solution for OTC derivatives, “but we don’t think it is the only one and we should look at other solutions”.

“If we were able to have a platform where prices became more transparent, where we know what is trading during the day, it would help the bank [and] the buy side to have a better view of what the real price is,” he said.

Mr Gay said it was for regulators to decide how this should be done. However, he stressed it would be possible for banks, brokers and other parties to mark contracts to market themselves.

Other critics of the proposed regulation have pointed out that if central clearers took on a widening spread of risk, they would end up looking very much like investment banks – and might need to be regulated similarly. [Emphasis added.]

You don’t say.

In other words, clearinghouses will perform the same economic function as large dealer banks–of absorbing and allocating default risk. They don’t make it disappear. They will be inter-connected. They will also pose systemic risks.

FT’s Lex has also noticed:

True, regulation that mandates clearing could weaken banks’ hand. But it is not only banks that might resist extending clearing requirements. Clearing houses themselves have fought to retain control of which products can be cleared. They need to mark positions to market in order to collect margin which, in the case of CDS, must reflect the possible payout in the event of an underlying default. Illiquid products, then, are unsuitable.

Whether clearing CDS, or other OTC products, becomes big business is yet to be seen – clearing is, after all, akin to a utility. But it therefore merits careful supervision. If multiple profit-driven clearing houses compete, this could muddy risk management. A seller of protection might appear moderately exposed within one platform but egregiously so across the system. [This is just another way of discussing the interconnection point.]

Regulators, too, should take a dim view of competition that focuses on margin requirements or the type of collateral accepted. Clearing helps to reduce risk in the system – not eliminate it.

Saturday’s FT has an article by the COO of the exchange BATS which similarly points to the fact that the introduction of multiple CCPs will effectively create the same sort of interconnection concerns and problems as the current dealer structure:

So what are the solutions? The US, for example, has single post-trade providers. While this facilitates competition between trading venues and lowers post-trade costs via processing economies of scale, the monopolistic position of the post-trade service provider results in a lack of efficiency and innovation.

A more pragmatic model is one in which a small number of competing CCPs interoperate. For example, CCPs A, B and C provide interoperating C&S services for multiple MTFs (multilateral trading facilities) and exchanges.

Trading/clearing participants could select their preferred CCP rather than one designated by the MTF or exchange. Participants could also elect to clear all of their business through a single CCP, providing netting possibilities which in turn allow for more efficient margining and settlement. Direct competition would also oblige CCPs to focus on improving cost, efficiency and service.

To date, with the exception of a handful of arrangements, there has been little progress in implementing interoperable clearing models, especially interoperable clearing models involving three or more CCPs.

Within this context, it is important to note that interoperable clearing poses additional risks that need to be appropriately mitigated. In particular, under an interoperable clearing model, CCPs are no longer exposed only to risk from their clearing members but also to financial and operational risk from the CCPs with which they interoperate. Where CCPs were previously “risk aggregating”, they thus also become “risk taking” entities. Again, this must be mitigated.

BATS Europe supports a model under which the CCPs margin each other on a fully collateralised basis, as if the other CCP were just like any other clearing member. This approach minimises the interdependence of CCPs under interoperation and thus seeks to ensure the continued systemic stability of the current system.

The CCPs will continue discussions of whether there can be a more efficient interoperation framework in the future but this is likely to be more complex from a risk, legal, operational and regulatory view point and thus will take significant time to research and implement.

[Emphasis added.]

This dawning understanding that clearing is not a magic bullet, and which might create problems similar to or worse than the ones that it is intended to solve, reminds me of the old story about the Indian village infested by mice, that brought in cats to eliminate the mice, that brought in dogs to deal with the proliferation of cats, that brought in elephants to drive out the hordes of dogs . . . and then brought back the mice to rid themselves of the rampaging elephants.

The belief that clearing somehow eliminates risks is another example of magical thinking. It is another way of performing a particular economic function. The fact that it was not the mechanism by which vast numbers of market participants chose to perform this function raises, again, the question “why not?” Now, it is possible that some particular transaction cost precluded this choice, and that a mandate or some form of regulation will reduce this transaction cost. But inasmuch as the entire argument for clearing has been predicated on magical thinking, and indulging the Nirvana fallacy, rather than a hard-headed analysis of the REAL trade-offs, there is room for considerable skepticism that this is actually the case.

Instead, as a result of the intellectual laziness and groupthink that has brought us to this point, we are far more likely to find ourselves in the position of those Indian villagers, who didn’t think more than one step ahead; who didn’t consider the consequences of a major intervention into their ecology (and as Vernon Smith points out, markets reflect a form of ecological rationality); and who didn’t pause to wonder whether their intervention could actually make things worse.

Thus, in my view it is to be regretted that the WSJ’s story about the death of derivatives overhaul is an exaggeration. Would that it were so!